Technical analysis

29 June 2016

CERN Finance Club

[email protected] Introduction

► The two main types of investment analysis used in ‘traditional’ investing ► Last time: Fundamental analysis ► Today:

Warren Buffet “Oracle of Omaha”, one of the most successful investors of all time, uses simple concepts from fundamental analysis

► Next time: Quantitative analysis ► Used in quantitative/systematic/algorithmic trading ► “Searching for patterns”

2 Fundamental vs Technical

Fundamental analysis Technical analysis

► Assumption: markets may ► Assumption: all information is misprice a security in the factored into the price short run but the “correct” price will eventually be reached ► Study past market data, primarily price and ► Determine price by looking at “fundamentals” ► Example measures: ► Trend lines ► Example measures: ► Moving averages ► Equities: company’s ► Many, many more financial statements ► Bonds: credit ratings ► Currencies: interest rates

3 Assumptions

► Technical analysis is based on three main principles:

1. The market discounts everything ► Fundamental factors already priced in

2. Prices move in trends ► “The trend is your friend”

3. History tends to repeat itself ► Market psychology provides consistent reactions to similar market stimuli

4 Chart types

Line chart ► Usually plot the Close price vs time

5 Chart types

Bar chart ► Offers more insight – Open, High, Low, Close

6 Chart types

Candlestick chart ► Colour identifies bullish/bearish periods

7 Volume

► Volume = number of shares/contracts traded in a given period ► i.e. the amount of trading activity ► Gives a measure of liquidity

► The higher the volume, the more important a price change/trend/

8 Trend

► The trend is the direction in which the market is moving

► There are three main types of trends:

► Uptrend: higher highs, higher lows

► Downtrend: lower highs, lower lows

► Sideways trend

9 Trend length

► Long-term: ~years ► Medium-term: ~months ► Short-term: ~days

► A long-term trend is often composed of several intermediate trends in the opposite direction, also called “corrections”

10 Trendlines

► Uptrend line is a straight line drawn at the lows of an upward trend ► Represents the support

► Downtrend line is a straight line drawn at the highs of a downward trend ► Represents the resistance

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► Support and resistance levels act as floor and ceiling for price

► Support ► Price level that a security seldom falls below ► Price level at which a lot of traders are willing to buy

► Resistance ► Price level that a security seldom surpasses ► Price level at which a lot of traders are willing to sell

12 Support and resistance

► Support and resistance can reverse their roles if the price “breaks through” one of these levels

13 Chart patterns

Head and shoulders ► Reversal pattern ► Usually after a long rally – because nothing lasts forever

Neckline

14 Chart patterns

Double top/bottom (or triple top/bottom) ► Reversal pattern ► After a sustained trend, price tests support/resistance level twice and is unable to break through

15 Chart patterns

Cup and handle ► Continuation pattern ► Temporary fall perhaps due to bad news, but fundamentals eventually improve ► Handle forms as those who bought at the old high and who felt burned by the long decline take their money and get out

16 Chart patterns

Flags and pennants ► Continuation patterns ► Short-term retracement from the main trend ► Difference is whether trendlines converge or not

17 Chart patterns

Gaps ► A large difference in prices between two sequential trading periods, usually accompanied by high volume ► Usually occur after significant news (e.g. earnings announcement)

18 Moving averages

► = average price over previous N periods ► Smooths out some of the noise that is found in day-to-day price movements, giving a clearer view of the price trend ► The longer the time span, the less sensitive the moving average to price changes

► Simple moving average (SMA): equal weighting ► Exponential moving average (EMA): exponential function weighting with greater weight to most recent periods 19 Moving averages

► Example trading signals

► Price moves above (bullish) or below (bearish) MA line

► A shorter MA crosses a longer MA from below (bullish) or above (bearish)

20 Indicators Moving average convergence/divergence (MACD) ► indicator ► MACD = difference between two EMAs (usually EMA12 - EMA26) ► Signal = EMA of the MACD (usually 9 days) ► Used to spot changes in the strength and direction of a trend ► As before, trading signal is given by a MACD/Signal line crossover

MACD Signal 21 Indicators

Bollinger Bands

► Bands plotted two standard deviations away from a MA

► Give a measure of

► Security is overbought (or oversold) when price moves above (or below) the band

22 Indicators

Relative strength index (RSI) ► Momentum oscillator ► Measures velocity and magnitude of price movement

(“up” days)

(“down” days)

► Security is considered overbought when RSI > 70

► Security is considered oversold when RSI < 30

23 Bibliography

► John J. Murphy ► Technical Analysis of the Financial Markets

► Charles D. Kirkpatrick, Julie R. Dahlquist ► Technical Analysis: The Complete Resource for Financial Market Technicians

► Investopedia ► http://www.investopedia.com/university/technical/

24 Backup

25 Fundamental analysis

► Definition: Fundamental analysis involves analysing a business, its industry/competitors and the economy in order to make financial forecasts

1. Analyse the underlying factors 2. Determine the intrinsic value 3. Compare the intrinsic value to the current market price

► Market price < Intrinsic value: BUY ► Market price > Intrinsic value: SELL

► The various fundamental factors can be grouped into two categories: ► Qualitative factors – e.g. quality of management, brand-name ► Quantitative factors – e.g. revenues, profits

26 Fundamental analysis

► Qualitative factors ► Business model, market share, competition, industry, regulation, management, corporate governance

► Quantitative factors ► Financial statements: balance sheet, income statement, cash flow statement ► Financial ratios: profitability, debt, liquidity, valuation

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